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GFC (Liquidity Risk (general (We now consider two key types of liquidity…

- - - - • Some banks were financing large amounts of long-term assets with short-term funding, and in particular short-term funds from the wholesale financial markets. When lenders became more reluctant to re-lend, these banks collapsed because they did not have the liquid assets they needed to carry on in business.
        
        The GFC resulted in some runs on banks and a loss of liquidity in the wholesale money markets. Losses on CDOs threatened some banks with insolvency, and led to the collapse of Lehman Brothers. Inability to sell CDOs in the market, and concerns about the losses that other banks might have been hiding led to a loss of liquidity (willingness to lend) in the financial markets.
        Inability to obtain liquidity or to securitise any more loans also meant that commercial banks had to cut back lending to customers.
      - In normal circumstances this should be no problem. Banks keep some liquid assets, including cash, sufficient to meet a normal demand for withdrawals. Customers trust banks with their money, so do not demand to withdraw their deposits.
        When banks need extra liquidity, they can normally obtain it in the wholesale (money) markets, although this is short-term funding.
  - - - Before the GFC, banks were able to combine the need for liquidity with maintaining limited amounts of liquid assets. This was because of trust in the banking system.
        Many customer deposits could be regarded as ‘sticky’ – i.e. although they could be withdrawn on demand, most deposits were likely to remain with the banks.
        The GFC led some customers to question their trust in banks.
      - Nature of wholesale funding
        A bank accepts deposits and extends loans to borrowers. If lending growth exceeds the level of client deposits, a bank funds the gap via ‘wholesale money’, which is money received from third-party sources other than the bank’s clients. Wholesale funds can be sourced from both domestic and global capital markets, and are generally sourced in large quantities from financing syndicates or individual funding sources.
        
        Wholesale funding is considered to be ‘nervous money’, which means that it is not as secure as retail funding. A significant proportion of wholesale funding is short term (e.g. a very common type of wholesale funding is for a three-month term).
        
        A bank could manage the risk of ‘wholesale money flight’ by reducing its reliance on wholesale funding. One approach could be to narrow the gap between deposits and loans, which could be achieved by attracting more retail deposits and/or limiting lending.
        
        Generally, the easiest lever for banks to regulate is the volume of lending because it is more challenging to attract new deposits without increasing the rate being offered.
        
        US commercial banks were at a risk of ‘wholesale money flight’ by virtue of an excess of loans over deposits.
  - - - trust in banks
        
        Before the GFC, banks were able to combine the need for liquidity with maintaining limited amounts of liquid assets. This was because of trust in the banking system.
        Many customer deposits could be regarded as ‘sticky’ – i.e. although they could be withdrawn on demand, most deposits were likely to remain with the banks.
        The GFC led some customers to question their trust in banks.
        
        To maintain confidence in banks and enable banks to keep access to funding, two guarantee schemes were introduced in Australia during the GFC
        
        trust schemes image!!!!
        
        Banks generally only hold minimal liquid funds to satisfy ‘ordinary’ demands for cash and may be unable to meet extraordinary demands for liquidity by depositors quickly enough, which has been shown to lead to depositors’ increasing panic. In these circumstances, a bank may be forced to seek a lifeline in the form of a short-term or long-term credit line from another financial institution or the government.
        
        In a recent report, the national banking regulator APRA recommended that Australian banks needed to lift their holdings of cash and similar assets by 2 percentage points to rank among the safest in the world. In dollar terms, this is likely to mean the setting aside of somewhere between $15 billion and $20 billion across the sector (Whalley 2015).
        
        One way to measure a bank’s ability to withstand liquidity shocks is based on ratio analysis,
        for example by examining the deposits/loans ratio and deposits/total funding ratio.
  - - - Liquidity risk is of particular importance to banks and similar financial institutions. The main functions of a stable banking system are:LID
        • accepting deposits;
        • granting loans and advances; and
        • acting as an intermediary mechanism between depositors (those with surplus cash) and borrowers (those with a deficit of cash).
        
        Banks maintain a buffer of liquid assets that they and the regulators determine is prudent to have in ordinary circumstances.
    - - liquidity risk types image!!!
        
        Funding liquidity risk at specific institutions
        
        Funding liquidity risk is defined broadly as the risk that a bank may not be able to meet its expected and unexpected current and future cash flow and collateral needs without affecting its regular daily operations or its financial performance.
        
        Systemic shortage of funding and market liquidity risk
        
        A systemic shortage is the more destructive type of liquidity risk. A systemic shortage of funding affects multiple banks and is often caused by the loss of market participants’ confidence in the stability of banks, as occurred during the GFC.
        
        Market liquidity risk is the risk that a bank will not be able to offset or liquidate a position at an adequate price because of insufficient market depth or market disruption.
        
        A market liquidity shortage, similar to a funding liquidity shortage, is generally caused by a loss of confidence among market participants. A significant drop in confidence by market participants leads to a sharp rise in uncertainty about asset values and the financial strength of potential counterparties. Confidence in the market is necessary to promote a healthy level of activity— with buyers and sellers establishing clearing prices. Lack of confidence can lead to market players disengaging from financial markets, resulting in illiquid markets.
        
        A direct consequence of market illiquidity is that assets that may have been thought to be easily convertible into cash are not, at least not at the prices expected previously, which creates liquidity problems for individuals and institutions. This, in turn, heightens the credit risk of market participants, leading to a further exacerbation of market illiquidity.
        
        figure 4.2!!!
      - KE image!!!!
- - - - the loan/core deposit ratio of large commercial banks in the United States had increased significantly since 1992, growing from just under 100 per cent in 1992 to more than 140 per cent in 2000 (Wetmore 2004, p. 103). Across all US commercial banks, the loan/deposit ratio grew from around only 20 per cent in 1945 to over 100 per cent in 2001 (Wetmore 2004, p. 99). This indicated that total loans advanced to borrowers exceeded total deposits, effectively meaning that advances to borrowers were partially financed by other sources, including foreign loans. At the same time, the loans/assets ratio also grew from around 20 per cent in 1945 to almost 60 per cent in 2001 (Wetmore 2004, p. 99).
        
        A number of factors contributed to this:
        • a decline in deposits
        –– declining interest rates and strongly performing stock markets encouraged individuals to move funds from savings accounts to other investments; and
        –– consumption boomed in the benign economic environment, leading to a decrease in the rate of savings
        • an increase in lending
        –– a growing economy encouraged increasing lending activity by both firms and individuals; and
        –– low interest rates increased the demand for cheap forms of capital.
        
        US commercial banks were at a risk of ‘wholesale money flight’ by virtue of an excess of loans over deposits.
      - These techniques included:CCHV
        • credit derivative instruments;
        • collateralised loan obligations;
        • hedging; and
        • various forms of insurance.
        
        Banks traded the complex structured products with each other, and this interbank diversification allowed banks to further expand balance sheets and take on higher risks.
        
        As the liquidity and solvency problems in the global banking sector became widespread,
        the banks’ trust in one another was severely compromised, resulting in a dramatic escalation in borrowing costs between banks, as shown by movement in credit default swap (CDS) premiums.
        A credit derivative is a contingent claim that allows the trading of default risk separately from other sources of uncertainty; it represents an insurance contract against the default of the underlying entity. A CDS is the most standard form of this contract available in the financial markets. For a bank, a CDS premium reflects the cost that it is charged to borrow funds from another bank.
        The significant rise in these costs meant that in a number of instances it became impractical for banks to borrow funds from each other, and the banking system, which was heavily reliant on the availability of wholesale funding as described earlier, came close to a collapse.
        
        As a greater number of increasingly complex products were created, the quality of investors’ understanding of the underlying risk deteriorated, with the real risk of the product becoming apparent only as the credit crisis unfolded
        
        Many market participants accepted the published credit ratings of complex structured products on face value, implicitly trusting in the assessments made by third-party providers (i.e. credit rating agencies). As the GFC unfolded, this trust rapidly evaporated. It was later identified in many cases that the assumed ‘independent’ third-party providers had been paid for the rating by the issuers of the products.
    - - • Defaults on sub-prime losses increased.
        • CDOs and other securitisation instruments lost their value.
        • Loss of confidence banks: which banks were hiding losses?
        • Reluctance of banks to lend to each other, precipitating the collapse of several banks
        • Lehman Brothers failed; others were taken over or rescued by their governments.
        • Inability to obtain liquidity or to securitise any more loans also meant that banks had to cut back lending to customers.
        • Loans became either difficult to obtain or obtainable only at high interest rates.
        • Businesses and consumers cut back on spending. Some got into serious financial difficulty.
        
        Where banks took action to write down their financial assets, they increased the risk of breaching their capital adequacy standards. Under banking regulations, banks were required to maintain adequate capital reserves. As their asset values fell, banks had to either find additional capital or stop lending. In many cases, banks had insufficient buffers to absorb the write-downs.
        
        Banks began to sell off assets and scale down lending by limiting new debt and/or not rolling over existing debt. This was driven by: PCW
        • preservation of capital ratios—many banks faced substantial losses on the value of assets that they were holding; these losses were recognised in the equity, and consequently the capital ratios of banks declined;
        • significantly increased conservatism in extending credit; and
        • dramatically increased cost and availability of wholesale funding.
    - - • Businesses and consumers cutting reducing spending led to recession
        • Economic recession: governments sought to protect their economies
        • Greater protectionism in world trade
        • Banks needing to improve capital adequacy and liquidity: greater reluctance to lend
        • Therefore, reduced access to credit for individuals and businesses
        • Rising unemployment, business failures
        • Lack of confidence in financial markets
        
         Banks tried to improve their capital position as much as possible. Assets (bonds, loans) were written down in value and where possible, some were sold.
         With less capital and less liquidity, banks relied increasingly on their central bank for financing. They also became more conservative with their own lending to customers, to reduce the risk of further losses.
         With restricted access to credit, and falling incomes due to economic recession, companies and individuals have reduced their investment and consumption. Unemployment has risen in many economically-advanced countries.
        
        There have been moves towards greater protectionism in international trade, as governments seek to protect their national economies.
- - - - liquidity scheme image!!!!!
        
        the Australian government set up two guarantee schemes during the GFC to promote confidence and assist banks to continue to access funding:
        
        Financial Claims Scheme: This scheme is administered by the Australian Prudential Regulation Authority (APRA), which initially provided protection for deposits of up to $1 million per customer. The cap on deposits guarantee was subsequently reduced to $250 000 in February 2012.
        
        Guarantee Scheme for Large Deposits and Wholesale Funding: Under this scheme, eligible authorised deposit-taking institutions (ADIs) were able to access a guarantee for both their deposit-holders that held more than $1 million and wholesale funding providers for a fee. This scheme closed to new liabilities in March 2010.
        
        In a recent report, the national banking regulator APRA recommended that Australian banks needed to lift their holdings of cash and similar assets by 2 percentage points to rank among the safest in the world. In dollar terms, this is likely to mean the setting aside of somewhere between $15 billion and $20 billion across the sector (Whalley 2015).
        
        RBA _ liquidity support for banks
        
        • In September 2008, the RBA also provided direct liquidity support to the banking sector. Two of the measures were:
        
        a USD 10 billion swap facility with the US Federal Reserve, to allow Australian banks to access short-term USD funds; and
        
        a short-term deposit facility, the RBA Term Deposits (RBATD), to ADIs. Institutions bid for these deposits under an auction system.
        
        • In October 2007, the Reserve Bank of Australia (RBA) widened the range of securities it was willing to trade under repurchase agreements (REPOs) to include AAA-rated mortgage-backed prime securities and AUD-denominated asset-backed commercial paper; it also extended the term of these agreements. By entering into a REPO, the RBA purchases a security and at the same time agrees to sell it back to the seller on an agreed future date for an agreed price. The difference between the purchase and resale price reflects the cost of funding being provided by the RBA.
        
        • In October 2008 and again in November 2009, the Australian Office of Financial Management (AOFM) was directed to invest a total of AUD 16 billion into the RMBS market, to support competition by a diverse range of lenders in the mortgage market. The Australian government recognised that the RMBS market provided an important source of funding for smaller lenders to compete with major banks; it also acknowledged that liquidity in the RMBS market has markedly decreased since mid-2007, constraining the ability of lenders to access funding from this source.